FASB Hoists Red Flags Higher for Taxman

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A new interpretation from the Financial Accounting Standards Board has some companies worried that it will help point Internal Revenue Service examiners straight to those items on their tax returns that are aggressive or complex.

FASB’s July 13 interpretation of FASB Statement No. 109, Accounting for Income Taxes, aims to clarify an existing law and improve comparisons between companies by providing consistent recognition thresholds and measurements to account for uncertainty in income taxes. In the process, however, it may also hoist red flags higher for the taxman.

“It will give the IRS a real boost in its efforts to identify and examine a company’s most controversial tax positions,” comments Robert Willens, a tax analyst at Lehman Brothers. “I don’t think FASB was intending to help the IRS, but it’s certainly a result.”

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FASB issued the interpretation because Statement 109 does not include specific guidance on how to address uncertainty in accounting for income-tax assets and liabilities. As a result, companies have used varied interpretations and practices. The new standard and the disclosure requirements would make it easier to identify a company’s level of uncertainty on the tax benefits it has taken.

The interpretation affects the recognition and measurement phases of accounting for uncertain tax positions, among other aspects. For example, under the new interpretation, companies must assume that tax authorities will examine the uncertain tax position. That leaves companies calculating only the possibility that their tax position will pass muster with the IRS — not the possibility of the IRS finding it in the first place.

“Under current practice, you would also take into account the high possibility that the item in question would not be examined at all,” says Willens, but under the new standard, “you can’t take into account the audit lottery, the possibility it won’t be examined.”

In the measurement phase, companies must apply the “more likely than not” standard when deciding when tax benefits may be recognized. In this interpretation, “more likely than not” is a likelihood of greater than 50 percent that the IRS would allow the item to stand.

Companies must disclose, in the aggregate, “more likely than not” tax positions, which, by definition, entail a sizable amount of doubt and are positions with so much uncertainty that a company does not take a full financial benefit on the financial statements. The difference between the tax benefits on the financial-statement amount and the tax return would reflect a company’s uncertainty about its tax positions, says Willens: “That would be where they [the IRS] would want to zero in on.” In an examination, the IRS would be within its rights to request that a company disaggregate the tax positions, something that would give the agency a roadmap to the uncertain tax positions, he added.

FASB expects the guidance to improve financial reporting by facilitating increased relevance and comparability in financial reporting of income taxes, because all tax positions accounted for in accordance with Statement 109 will be evaluated using consistent criteria. The interpretation, FASB Interpretation No. 48, applies to for-profit and not-for-profit entities and is effective for fiscal years beginning after December 15, 2006.

“This is one of the best things that has happened to the IRS in a long time,” muses Willens.